How to Calculate And Tnterpret the Moving Average Convergence Divergence

Introduction

The Moving Average Convergence Divergence (MACD) is a widely used technical indicator in financial markets, particularly in technical analysis. It is generally used to identify prospective trends, reversals, and momentum in an asset’s price.

How to Calculate the Moving Average Convergence Divergence?

Calculating the MACD involves the following six steps.

Step 1: Choose the Period:

The MACD is typically calculated using two distinct periods: a shorter (commonly 12 period) and a longer (often 26 period). Depending on your trading or analysis preferences, these intervals can represent days, weeks, or another timeframe.

Step 2: Calculate the Shorter Exponential Moving Average (EMA12):

Gather the asset’s closing prices for the chosen shorter time (e.g., 12 days).
Calculate the simple moving average (SMA) for these closing prices for the selected time period.
To compute the EMA for the current period, use the exponential smoothing formula:

EMA today = (Closing Price today * Smoothing Factor) + (EMA yesterday * (1 – Smoothing Factor))

The smoothing factor for a 12-period EMA is typically 2 / (12 + 1) = 0.1538.

Step 3: Calculate the Longer Exponential Moving Average (EMA26):

Repeat the process for the longer EMA as you did for the shorter EMA, but this time use the closing prices for the longer period (e.g., 26 days).

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Step 4: Calculate the MACD Line:

Subtract the EMA26 value from the EMA12 value to calculate the MACD line.

MACD Line = EMA12 – EMA26

Step 5: Calculate the Signal Line:

Calculate a 9-period EMA of the MACD line to generate the signal line.

Signal Line = 9-period EMA of MACD Line

Step 6: Calculate the MACD Histogram:

When determining the MACD histogram, the signal line value is subtracted from the MACD line.

MACD Histogram = MACD Line – Signal Line

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How to Interpret the Moving Average Convergence Divergence?

A bullish signal is given when the MACD line rises above the signal line. This indicates the possibility of an uptrend.
When the MACD line drops below the signal line, however, a bearish signal is generated, suggesting the possibility of a decline.
The MACD line confirms a bullish signal when it rises above the signal line.
A negative signal is strengthened when the MACD line falls below the signal line.

What are the Limitations of the Moving Average Convergence Divergence?

MACD is a lagging indicator, which means it generates signals based on prior price data.
In choppy or sideways markets, MACD can give erroneous signals, resulting in losses.
MACD can be affected by market noise and changes in the near term.
Traders may be tempted to change MACD settings to fit past data, which can lead to optimization bias.